Why Gold-Related Investments Are Slowly Becoming Worthless

by: John Lindauer

Recently I received a comment from someone who claimed former Federal Reserve Chairman Alan Greenspan has suggested we should abandon the Federal Reserve and move back to gold or adopt a "currency board."

Does that mean investors should take another look at gold? At buying gold-related stocks and funds such as Sandstorm (SNDXF.PK), Royal Gold (NASDAQ:RGLD), Global X (NYSEARCA:GGGG), Direxion (NYSEARCA:DUST) and Market Vectors (NYSEARCA:GDX)?

The Pros and Cons of Gold

On the plus side for gold we all know it is virtually indestructible and that the supply only increases slowly as new gold is mined. On the other hand, we also know that the world is changing and that, unlike bonds and other assets, gold earns no income and has costs associated with its storage.

Today there is a market for gold and it exists for a number of reasons - because gold is demanded as a "safe haven" or store of value, for jewelry particularly in countries such as India, for certain industrial applications, and for false teeth. Indeed, in countries such as India and other underdeveloped countries gold often does a double duty as both jewelry and a way by which women can accumulate an indestructible store of relatively liquid assets.

Moreover, some people and politicians, for example Congressman Ron Paul, believe the value of the dollar would be enhanced and stabilized by the restoration of the gold standard or some other connection between the dollar and gold. Should such a connection be reestablished they are correct in thinking that there would be a dramatic increase in the demand for gold and its price would undoubtedly rise.

On the supply side there is a general understanding that the market is affected by the huge stock of gold jewelry, which can be quickly sold as jewelry or melted down and resold as raw gold, by sales of the gold held by people as a store of value when they find other ways to store value such as in stocks and bonds, by sales of stocks accumulated by traders such as John Paulson's hedge fund, and by the continuing mining of gold.

Particularly overhanging the supply side of the gold market are the huge gold reserves countries such as the United States still hold in their vaults from the days when their currencies were backed by gold. For example, the central banks of euro-challenged countries Greece, Italy, Spain and Prortugal hold in excess of 3000 tons. A good part of that tonnage is almost certain to end up on the market in the near future.

Many other countries also hold substantial amounts of idle gold from the days it backed their currencies. The United States alone holds more than 370 million ounces, some of it in trust for other nations and organizations. These reserves once backed the dollar and other currencies. Today they are sitting idle in the vaults of Fort Knox and the New York Federal Reserve Bank. These and similar reserves around the world, since they now serve no identifiable purpose, are virtually certain to hit the market sooner or later.

Where is the price of gold headed?

The basic answer is that in the long run the price of gold can only go down. And it will keep going down until mining virtually stops. This will occur as the world's economies and banking systems continue to modernize and gold long-held in vaults to back currencies comes on the market. As it stands, in the long run the price of gold will almost certainly fall as the supply in the market continually increases far faster than the demand.

The long-run decline is under way for a number of reasons. For example, modern dentistry now relies on other commodities for false teeth; access to banks and stock markets and other assets is spreading rapidly in gold buying countries such India so that women, as women already do in the West, can now hold their assets in banks and securities and other assets instead of wearing them.

Also in the long run, the older less knowledgeable generations of Geithners and Ron Pauls will pass out of positions of power - so that the kinds of uncertainty and ignorant national and central bank decisions now triggering economic collapse, such as those now prevailing in the United States, will finally cease, thus ending the demand for gold as a safe haven for investor's wealth.

On the other hand, there is always a substantial time when there are major changes in an economy's culture and knowledge. That's another way of saying that large amounts of gold jewelry are going to be demanded in India and other such countries for years to come. Similarly, the macroeconomically illiterate politicians and central bank appointees of Europe, the U.S., and elsewhere will not give way for years.

But the trend toward sustained prosperity is under way and it means significantly lower gold prices in the future as declining demand meets an increasing supply - not just from increased production through the use of modern mining techniques but also as nations sell their useless reserves and women in underdeveloped countries convert their gold jewelry to income-earning assets such as stocks and bank deposits.

Of course, hanging over the long-term trend of a declining price of gold is the possibility, however remote, that gold will again be used to back national currencies. Also it is possible that more people in desperately poor nations such as India, and Somalia, will become rich enough to start buying jewelry and accumulating wealth faster than banks and other investments will become available to them. Such an expansion of the demand for gold would certainly tend to increase its price by swamping the downward pressures.

Are Influential Opinions About Gold Changing?

Are the opinions of influential people such as Alan Greenspan changing so that a return to gold backing of the dollar and other currencies is possible as the comment suggests?

The basic answer is No.

I respectfully suggest the commentator took Greenspan's gold standard comments out of context. In the interview Greenspan mentions a "currency board" as an alternative to the gold standard. And that is exactly what we have - our currency board is the Board of Governors of the Federal Reserve System.

The reality is that neither Greenspan nor any other trained macroeconomist has called for a return to the gold standard as the basis for the quantity of money in our economy - because they know the gold standard's absolutely perfect record - it has absolutely failed and been abandoned every single time it has been tried.

Why Not Back Currencies With Gold?

The problem with the gold standard or somehow tying an economy's money supply to gold is quite simple: a complex market economy such as that of the United States or the eurozone at all times needs "enough" money in circulation so that ever changing mega-billions of individual transactions can occur every day - never too little money so there is not enough spending such that a recession results nor too much money so there is an inflation caused by too much spending.

Inflation and recessions are very debilitating to businesses and people. So every country in the world whether free or socialist or autocratic has come to the conclusion that it needs a central bank, not a gold standard or a currency somehow related to gold, to make sure it at all times has enough money to have prosperity - not too much to cause inflation due to excessive spending nor too little to cause inadequate spending and recession.

For better or worse, long ago when markets and money replaced barter and the world adopted banks and credit cards and complex financial transactions gold became just another metal useful for filling teeth, wedding rings and jewelry. In other words, the world's economies are now too complex for a currency backed by a commodity whether it be gold or pork bellies or beads or land. In the real world the gold standard long ago outlived its usefulness and has been proven to be a total failure too many times - so it's gone the way of indian wampum and the great auks and dinosaurs.

Beware of Gold-related Investments

Since the gold standard won't be back investors should be wary of buying gold or the shares of gold-related companies because someone claims gold will always have value, or suggests gold may again "back" the dollar or some other currency, or claims that having gold associated with our currency would somehow "fix" inflation or enhance the value of and stability of the dollar.

The reality of today's world is that gold won't return to its previous eminence and its long-run price prospects are poor. But as a great economist once pointed out "in the long run we're all dead." In other words, in our lifetimes gold will always be in demand at some price and that price will fluctuate around gold's trend of long-term decline. The decline is under way. It began when nations went off gold backing for their currencies, dentistry advanced, and hundreds of millions of women in underdeveloped counties began to have access to banks, stock markets, and other ways to store their wealth and earn an income from it at the same time.

In our lifetimes the price of gold will continue its long downward spiral in response to gold's basic underlying market forces. On the other hand, the price of gold on any particular day will fluctuate, often significantly, as new buyers and sellers appear - so some traders will make lots of money and some will lose.

The only thing certain is that long-term investors will lose as the price of gold continues to inexorably trend toward the cost of storing it. Long-term investors should sell their gold and gold-related stocks as soon as possible.

That's what I think will happen and what gold investors should do. What do you think?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.